Interactive Worksheet on Partnership Accounts (2)
by Ken Delaney-Moore, Sheffield Hallam University
This worksheet deals with:
- Partners capital accounts
- Accounting for Goodwill upon a change in the profit sharing ratio
- The re-valuation of assets upon a change in the profit sharing ratio
After having completed the worksheet you should have a greater understanding of these issues.
If you are unfamiliar with partnership accounts it might be beneficial for you to work through the interactive worksheet on partnership accounts (1) which deals with the following issues:
- Partnership creation
- Contents of the Deed of Partnership
- Profit-sharing in a partnership
- Appropriation accounts
- Partners current accounts
Taken in conjunction with this worksheet you should be prepared for the objective assessment on partnership accounts.
Partners Capital Accounts
All matters concerning profit-sharing and short-term drawings are recorded in the partners' current accounts. This means that the capital accounts are only likely to record the more substantial, long-term items such as capital contributions or redemption, and the type of changes referred to further in this worksheet.
The principle governing all capital accounts remains the same:
|A. Partner, Capital account|
|Transactions causing a decrease in the amount owed to partners are recorded as debits||Transactions causing an increase in the amount owed to partners are recorded as credits|
This theme recurs throughout the following notes and exercises.
Accounting for Goodwill upon a change in the profit sharing ratio
(Note: Goodwill is an intangible asset that may arise for a number of reasons, one of the most typical being that the business has, over a number of year, built up a loyal customer base).
Suppose Messrs. A, B and C have been in partnership for 20 years and have always shared profits / losses in the ratio 2:2:1 (respectively).
If the partners agree on a certain date that the goodwill is valued at £10,000 then it is fair to say that (unless the partners have agreed to something else) this 'extra value' belongs to the partners in the same ratio as that which is used for profit-sharing.
In the following questions you will be allowed TWO attempts at the answer, unless you are told otherwise.
Attributing goodwill becomes necessary when one of the following occurs:
- The existing partners decide to change the profit-sharing ratio
- A new partner enters the partnership
- A partner retires or dies
In all three cases the profit sharing ratio will change therefore ownership of the goodwill will change. Some partners will need to compensate others for this change. Compensation takes place before the new agreement takes effect by making entries in the partners' capital accounts. This can be done with or without the use of a goodwill account. The decision lies with the partners.
The general rules are:
a. If a goodwill account is to be opened:
debit the goodwill account; credit the partners capitals in the old ratio
b. If a goodwill account is NOT to be opened:
debit the capital accounts of those partners taking a larger share of the profits
credit the capital accounts of those partners taking a smaller share of the profits
Suppose Messrs. A, B and C decide that from now on profits are to be shared in the ratio 2:1:1 (remember the old ratio was 2:2:1)
A used to own 40 per cent of the goodwill i.e. £4000
A now owns 50 per cent of the goodwill i.e. £5000
A has therefore 'gained' £1000.
A and C have gained at B's expense. A and C therefore need to compensate B. This can be done either:
a. By opening a goodwill account
remember: debit the goodwill account the value of the goodwill; credit the partners capitals in the old ratio.
b. NO goodwill account - instead we make adjusting entries in the partners' capital accounts
We have already seen that A and C need to compensate B. We do this by taking value FROM A and C (debiting their accounts) and giving it TO B (crediting his account).
TUTORIAL NOTE: Some textbooks will tell you to 'credit in the old ratio, debit in the new'. This method is also correct; it has the same effect as method b). outlined above, but is a little longer (i.e. there are more entries to make). Ask your tutor which method is preferred for your course.
The re-valuation of assets upon a change in the profit sharing ratio
We have just seen that when a change in the profit-sharing ratio occurs it is necessary to value goodwill (because certain partners will need compensating). For the same reason it is necessary to re-value the assets of the business.
Example: G, H and I have been in partnership for 10 years and below is a summarised Balance Sheet as at the end of year 10:
|Bank||2,000||Balances are all zero|
H has recently decided to retire. Under the Deed of Partnership, profit/loss has always been shared in the same ratio as the capital contributions of each partner, which have remained unchanged.
There is no goodwill, but the buildings are re-valued at £24,000 and the machinery is re-valued at £2,000. Current asset values are correct.
To calculate exactly how much is owed to H we draw-up a re-valuation account. The rule is as follows:
- Any increases in asset values are entered as credits
- Any reductions in asset values are shown as debits
- The balance on the account is then found and shared-out in the old ratio.
|G, H & I: Revaluation account|
|Reduction in machinery value||2,000||Increase in buildings value||14,000|
|Balance to capital a/c's:|
The balance on the account is £14000 minus £2000 = £12000 (a net increase in value). This needs to be shared-out to the partners as follows:
*g : G has contributed £9000 out of a total of £18000 capital, and should therefore receive ( £9000 / by £18000 ) multiplied by the increase in value (£12,000). This equals £6,000 (the figure at *g should be £6000).
The Capital accounts of G,H and I are credited with the amounts *g, *h and *i. So, for instance, the capital account of G will receive a credit as follows:
In a similar way H will receive a further £4,000 credit to add to his balance b/d of £6,000; so the partnership owes H £10,000 at the time of his retirement.
The asset accounts receive the other half of the double-entry from the revaluation account (so, for example, the buildings a/c would receive a debit of £14,000).
Why not now try the objective assessment on partnership accounts?